Too Many Derivatives To Fail

By Daniel Indiviglio

The problem of firms being too big to fail became a prominent theme during the economic crisis. After reading a recent article on CFO.com about which firms face most of the risk in derivatives, I think it's easy to see why certain firms failing would be so problematic. In particular, there are five banks that control the vast majority of the derivatives market. Thus, almost by definition, they might be considered too big to fail based on their derivatives alone.

The article considers a report Fitch ratings issued earlier this month. Here's what CFO.com notes about the report's findings:

While derivatives use among U.S. companies is widespread, an "overwhelming majority of the exposure is concentrated among financial institutions," according to the rating agency's review of first-quarter financials.

About 80% of the derivative assets and liabilities carried on the balance sheets of 100 companies reviewed by Fitch were held by five banks: JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley. Those five banks also account for more than 96% of the companies' exposure to credit derivatives.

Those five banks shouldn't shock anyone -- they're the usual suspects. What might seem surprising, however, is the portion of derivatives exposure of those mere five banks. That's probably part of what prompted the Justice Department to begin looking into the derivatives market recently. Even beyond competitiveness concerns, spreading that exposure over a larger number of financial institutions would make a lot of sense from a systemic risk standpoint. The failure of any one of those firms would send our financial system back into crisis.

Also in the report, Fitch confirmed what some concerned with too burdensome derivatives regulation have been saying, via the CFO.com article:

While "derivatives trading by utilities and energy companies appear to be very limited," for instance, "most of the companies reviewed in both industries report the use of derivatives for hedging commodity risks," the report found.

Companies don't want their hedging practices that use derivatives to become more expensive due to new regulation. But one fascinating case Fitch also noted was Exxon. The largest U.S. energy firm had no derivatives exposure at the end of the first quarter. CFO.com notes that Exxon says, in its 10-K:

"The corporation's size, strong capital structure, geographic diversity and the complementary nature of the upstream, downstream and chemical businesses reduce the corporation's enterprise-wide risk from changes in interest rates, currency rates and commodity prices. As a result, the corporation makes limited use of derivative instruments to mitigate the impact of such changes. The corporation does not engage in speculative derivative activities or derivative trading activities nor does it use derivatives with leveraged features."